Ethan Ilzetzki on Exchange Rate Volatility, the ECB’s Strategy Review, and the Future of the Euro

Ethan Ilzetzki is an associate professor of economics at the London School of Economics and a research affiliate with the Centre for Economic Policy Research. Ethan is also a returning guest to the show, and he re-joins Macro Musings to talk about the European Central Bank’s big strategy review, the future of the Euro, and whether change is afoot in our international monetary system.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Ethan, welcome back to the show.

Ethan Ilzetzki:  Thanks for inviting me back.

Beckworth:  It's great to have you on. We were talking prior to this recording about our glory days at the US Department of Treasury. So if you ever want the background story on me, Ethan is the man to get it. So we had some good times there. I think you sat like three cubicles down from me.

Ilzetzki:  That's probably right. Yeah.

Beckworth:  Yeah. Yeah, and the interesting thing is, Ethan, I think everyone in that office... So, we were in the office. The Western Hemisphere Affairs had an interesting portfolio. Something exciting was happening in their countries. So, for example, our colleague Chris Kushlis had Argentina at the time there was a debt restructuring going on. I remember there was a Dominican Republic bank run crisis in that time, too. Was that in your portfolio?

Ilzetzki:  I was working on Uruguay at the time who also was experiencing a banking crisis, spilling over from the Argentine crisis.

Beckworth:  So a lot of interesting things going on. And my portfolio, lo and behold, was in Mexico and Canada. And so I had this really tame... I hate to say this, but almost boring... portfolio. I mean, lovely countries-

Ilzetzki:  You were Mr. NAFTA.

Beckworth:  Yeah. I mean, it was great. I was wined and dined by their diplomats, but you guys had all the fun, so I got to ride off your excitement and success in the countries that you covered. But great memories, great times there at the US Department of Treasury. And I'm glad to get you back on this show. You've been on before. I encourage our listeners to take a listen to Ethan's first show, if you haven't already. We'll provide links in the show notes. And that was a great discussion about the role of the dollar, the dollar's dominance, all the countries that either implicitly or explicitly peg to the dollar. And today we're going to kind of carry on that conversation, and move over to Europe, and then maybe come back and talk about, again, the international monetary system, of which the dollar is a big part. And I want to begin our conversation about the euro by first moving to a survey that you're a big part of. In fact, you head it up, as I understand.

Beckworth:  And this survey is similar to what we do in the US when they go out and they ask the top experts, "What do you think about certain issue?" So, why don't you walk us through what your survey is like and what you do, how you do it, and all that good stuff.

The Centre for Macroeconomics Panel of Experts Survey

Ilzetzki:  Right. So I manage the Centre for Macroeconomics panel of experts survey. So, the Centre for Macroeconomics is a UK-based research institute that is a collaboration between several top universities in the UK, and we have surveys of the top UK macroeconomists and a separate survey of top European economists. So it's around a hundred economists from all over Europe, very prominent economists, including members of the German Council of Economic Advisers, and very senior officials in the French Treasury, and other academic economists. Every month we conduct some survey of an interesting topical question and see what the consensus of view in the profession is on that topic. I'd be happy to talk about some of the recent interesting findings.

Beckworth:  Yeah, we'll provide links to your surveys. And I want to focus on one question in particular. But I was looking through your list of people that are on the survey, and the few names that stood out to me... And again, there's many, many more. But just some, including Roger Farmer, Jordi Galí, your colleagues Benjamin Moll, Ricardo Reis. They're on that panel. Correct?

Ilzetzki:  Yes. Yeah. Yeah. And many, many others. I don't want to single out any of my members.

Beckworth:  Well, three of those I just mentioned were on the podcast previously. So they deserve some mention. But yeah. Many prominent people. And again, it's very similar to the IGM panel we see here in the US, that people look at. It's fun. It's fascinating. So I want to move to a survey you did on November 2nd, and this one was on the ECB's review of its strategy. So, similar to what the Fed just completed. So, maybe tell us about this review process. And why did you do this survey now?

The ECB’s Strategy Review and Its Inflation Target

Ilzetzki:  Yeah. So, the European Central Bank is in a process of a review of its strategy. The strategy review is supposed to be completed this year, but because of COVID they've postponed it to the middle of next year. And by parsing through some of the statements by Christine Lagarde and other top ECB officials, it looks like a few of the major questions that are going to be on the agenda regard the inflation target, whether something more symmetrical should be done, whether unemployment should be taken more explicitly into account. And so, the reason we did this survey now is that in the US, a similar review did come out. You've talked a bit about how big or not big this change is, or whether this is a nod towards nominal GDP targeting or something else. And so we thought it would be interesting to see what top economists would recommend to the ECB in reformulating its monetary strategy.

Ilzetzki:  So we asked three questions. So, if you look at the mandate of the ECB at the moment, it says that inflation should aim to be at or below 2%. So the asymmetry of the target is almost explicitly stated in the bank's mandate, which is different from the Fed.

Beckworth:  So what does that actually mean? I know there's different interpretations, but what does that mean, "being close to"? What range would you put on that target?

Ilzetzki:  Right. You're absolutely right that this is a topic of disagreement. It requires some sense of humor to think that central banks can target inflation that accurately, so I think this is more about anchoring inflation expectations, but you're absolutely right that it's not clear what they're anchoring expectations to. If you take it quite literally, it seems that the ECB needs to respond aggressively to inflation exceeding 2%, but many statements of the ECB over the past decade, including statements by Mario Draghi and Christine Lagarde, seem to imply that overshooting 2% is not something they would necessarily frown upon. We were asking our panel whether the ECB should be more explicit in stating that it's going to allow inflation to exceed 2% to make up for periods of below 2% inflation, which would maybe come a little closer to doing something like nominal GDP targeting or price level targeting. And on this question, the panel was very, very strongly supportive... in fact, as close to as unanimity as we get on these type of surveys... that the ECB should allow inflation to overshoot and that the target should be more symmetrical.

We were asking our panel whether the ECB should be more explicit in stating that it's going to allow inflation to exceed 2% to make up for periods of below 2% inflation, which would maybe come a little closer to doing something like nominal GDP targeting or price level targeting. And on this question, the panel was very, very strongly supportive.

Ilzetzki:  We then asked whether unemployment should be taken as a second mandate. And again, there is some debate about whether that mandate already exists in the ECB's current mandate. But it's not as explicit as the Fed's dual mandate. And here too there was a strong consensus that unemployment should be at least a secondary aim of monetary policy in Europe. The additional question we asked was whether the panel would support changing the inflation target and raising it to a higher rate. The argument, perhaps, being that, with real interest rates so low, the risk of hitting the zero lower bound becomes higher when inflation is only 2%. Here views were more mixed, but, in fact, the majority opposed this view. I can't remember what I responded to this question myself. I don't feel strongly one way or another. I actually expected to hear more of the panel viewing this... On this question, the status quo won out among the panel.

Beckworth:  Well, that's not too surprising to me if there's a lot of Germans in this survey.

Ilzetzki:  It's pretty equally balanced across Europe.

Beckworth:  Okay. It's equally balanced. Okay. And that's the question I had. Do the Germans, who've been very cautious, and want to guard their reputation and institutionally keep the ECB very similar to the Bundesbank... Do you have any sense whether they were eager to allow any changes?

Ilzetzki:  If you look at recent statements by Jens Weidmann, you do see maybe some softening of the German position on some of these issues. But I find it nearly politically impossible for German officials to give too much ground on this. The objective, in the mind of the German policymakers in creating the euro, was to create a Europe-wide deutsch mark, to be blunt, not to be a Europe-wide Italian lira. And any concessions on this line would, in their view... And I'm not expressing my view. I'm just trying to iterate their opinions on this. Any concession on this is viewed, to them, as failing the mission that they set out with the creation of the euro.

Beckworth:  Well, maybe that's why, or at least one reason why, the overshoot, or making up for lost ground in a target, is more popular than actually raising the inflation target. Because it wouldn't be as big a change.

Ilzetzki:  Yeah. Absolutely. I feel like I've been put in a corner of being the German spokesperson here. So I think, again, the opponents of increasing the target feel like that is a genie that, if you take out of the bottle, you can't put it back in. While saying we need some make-up inflation for periods of low inflation, if inflation is high, that mandate kind of becomes irrelevant. So yes. I do see that there is a substantial... I mean, there's also questions whether the ECB, under the treaty agreements, has the mandate to simply announce a higher inflation target.

Beckworth:  Well, I would make the case to the ECB this way. If you do make-up policy, you're effectively approaching a price level target which is, I think, the ultimate kind of price stability. Inflation target, in theory, could be a random walk. Who knows where the price level is 10, 15, 20 years from now? Price level target, you're even more committed to what the German ideal is. So that'd be my sales pitch to them. But let me switch topics on this question, take it from a different angle. The ECB has not been hitting its inflation target. Is that fair to say?

Ilzetzki:  Yes. I think that's probably true of most advanced economies, central banks. Actually, just to come back to the survey for one second, I'd encourage listeners to actually go to the website, because what's really nice about this survey is that we ask the panel really to elaborate on their responses, so you can really get the whole view of... I recall Lars Svensson, who used to be the head of the Swedish central bank, on the panel, talking about research he's done related to price level targeting. So you can see the heterogeneity of views by reading the responses. But yeah, to come back to your question, yeah, it seems like central banks around the world, at least in high-income countries, have been finding it hard to hit the inflation target from below rather than from above, as we usually thought the problem would be.

It seems like central banks around the world, at least in high-income countries, have been finding it hard to hit the inflation target from below rather than from above, as we usually thought the problem would be.

Beckworth:  And in the Eurozone it seems, at least from my impression, which may not be right, that they're having a particularly tough time even compared to the Fed and other central banks. They've really fallen short. It raises the question, in my mind, as to whether this review, or really any review, is really the right question to be asking. Maybe the first question to ask is, "Why haven't they been hitting the target?" Is it because they can't? You might tell a secular stagnation story. It's beyond the central bank.

Beckworth:  Or you could tell another story. The central bank has been negligent. It simply has been too hawkish. It shouldn't have had rate hikes, or talked up rate hikes, or dialed back on QE. I mean, in the US I think you can make a reasonable case that the Fed shouldn't have tightened in 2015 and 2018. Now, how much difference that would have made on the inflation outcome, I don't know. But I got to think it would've been a little bit better. And so I wonder, in the case of the ECB, could they have done better, even if there are these other secular forces out there?

Ilzetzki:  This really depends on how effective you think measures like quantitative easing and forward guidance are. I think there are limits to what the ECB could have done, and I think that's true also of the Fed. I agree that it may have been premature to raise interest rates when the Fed did in the end of the decade. So you would have to argue that there is a very correlated mistake that all central banks are making, which is a possibility. There's some groupthink, and central bankers are all making the same errors. But if you see a lot of people making the same mistake, you have to wonder whether it's really a mistake or they have more control than they believe they do. To some extent, the world looks a little like what Bob Hall says about inflation, which he says you can treat it as an exogenous variable, that it's not… There's some driving force that has... I might be misquoting him, but I do recall him making that statement a couple of times. It does feel like there are other forces at play. I know we'll talk about my Brookings paper later on. But one of the things we do argue there is that there may be some factors, some secular factors, that are causing low rates of inflation and are making central banks' jobs more difficult in this regard.

Beckworth:  Yeah, I think that's a fair point and a reasonable take. There's something systematic going on. That we know. Right? You don't undershoot for a decade and not have something that... This isn't a case of bad luck. I mean, it would be incredibly bad luck to have this over a decade. Something systematic's going on. And the question is, is it something systematic within policy making or something systematic from outside? And maybe it's a bit of both. But I do think you can make a case something outside. And I look forward to that, as we get to it later in the show. Well, let's segue, then, from the ECB and this review to a discussion of the euro more generally. And you have a great paper titled *Why Is the Euro Punching Below Its Weight?* So let me begin our conversation on this paper by asking, has the euro been punching below its weight? And what evidence is there for that?

Is the Euro Punching Below Its Weight?

Ilzetzki:  Yeah. So that is a joint work with Carmen Reinhart and Ken Rogoff which is now coming out or out in Economic Policy Journal. And the first part of the paper really does try to document the extent to which the euro is punching below its weight. And let me put this maybe in a historical context. The ECB makes it very clear that being an international currency is not part of its mandate. It has a domestic mandate, although that is true of the Federal Reserve as well. But if you go back to the founders of the euro, they certainly had geopolitical considerations in mind in the creation of the euro. So certainly there was this Gaullist view that dates back to Jacques Rueff and Charles de Gaulle, that the exorbitant privilege that the US gains from dollar dominance is a major cost to France and to other European economies.

Ilzetzki:  And so part of the rationale of creating the euro was that the whole is greater than the sum of its parts and that, disposing of these 19 national currencies in favor of one, there would be some economies of scale that would create an international currency. What we do in this paper is we go over metric by metric of the international stature of currencies. And by pretty much every metric, the ratios are pretty much 60% dollar, 20% euro, another 20% for everything else. But what's particularly interesting is if you go look back at the period before the creation of the euro and then you take together the French franc, and the German deutsch mark, and a couple of other major European currencies, then too European currencies had, by many of these metrics, 20% of global market share, so to speak.

Ilzetzki:  And so we do think, to some extent, that there are economies of scale in currencies. That's why each US state does not have its own currency, for example. And so I think it is surprising that, 20 years later, we don't see the euro gaining more prominence. I mean, I can go through some of the metrics if you're interested, but essentially there's a very, very consistent picture of the euro being a far second, while it's an economy that's only about a third smaller than the US economy.

I think it is surprising that, 20 years later, we don't see the euro gaining more prominence... Essentially there's a very, very consistent picture of the euro being a far second, while it's an economy that's only about a third smaller than the US economy.

Beckworth:  Hence it is punching below its weight by every metric. It dawned on me as you were talking, an interesting counterfactual would be what if the UK had given up the pound and joined the euro, the euro had all of that extra weight behind it? Who knows if things would have been different. Maybe not, but that'd be an interesting counterfactual to play out.

Beckworth:  So, Ethan, you and your coauthors list five reasons why the euro punches below its weight, continues to punch below its weight. And it looks like it will be that way going forward. You list five, but there's two key ones that it seems are the most important. I know one you really stress, and that is the lack of safe assets in the eurozone. But also, the other big one was the dollar has a first mover advantage, this network effect. It's hard to break into a strong network effect. The economies of scale you alluded to earlier. So why don't you walk us through those stories?

The Two Stories of Euro Underperformance

Ilzetzki:  Yeah. So, there's one argument that the reason the euro is a far second is because number two is always going to be a far second, and that is simply the nature of international currencies. There are some major economies of scale and network effects that make a single currency the most dominant in the world. You can think of if a country denominates a lot of its trade in dollars, its corporations might also want to borrow in dollars. And then its central bank might want to have a lot of dollar reserves. And so there's some self-reinforcing aspect to all of this. So, just to take two historical examples here, the continental Europeans had tried to create a Latin monetary union during the British pound-dominated gold standard period as an alternative, and a silver-based continental European alternative. And that really never got to the prominence of the pound. Now, that could be because of some structural advantages that Britain had in trade and finance, but it also could be simply that number two is always going to be a far number two.

Ilzetzki:  We also have to remember that it took two world wars to get the pound off the dominance it had. And so there may be room for only one. But we think there are other reasons as well, as you noted. And the most important of which is an enormous scarcity of euro-denominated safe assets. So we have a striking chart in that paper, where we just compare what the quantity of dollar-denominated Treasury debt is compared to the euro public debt that could plausibly be viewed as safe. And the gap is really big. But even if you go to other types of assets... for example, corporate bonds... If you want to have a portfolio of corporate bonds, essentially US corporates are almost the only show in town because most of European corporate lending is through bank lending rather than through corporate bonds.

Ilzetzki:  You could create a synthetic safe asset out of a diversified portfolio of US corporate bonds. It's much harder to do so with euro-based bonds. Now Chinese corporate bonds are higher in volume, I think, than all euro corporate bonds at this point. On many dimensions, not just the public debt, there is a scarcity of euro-denominated safe assets.

Beckworth:  Yeah. That's an interesting issue. Now, the EU did recently issue some debt or is in the process of doing some tied to the COVID crisis. Right? But not enough to make a big dent?

Ilzetzki:  No. So this is still on a scale that is not going to provide enormous liquidity. You can see from the investor appetite for these bonds that there is a shortage. That is, there an enormous appetite for diversifying away from merely holding US Treasuries. But just the quantities aren't enough. And there is a question here of fiscal capacity, because the EU is not a federal government with taxation power. So at the end of the day, any EU borrowing is going to have to be backed by legislation from many countries to pass. So imagine that every time the US federal government wanted to borrow money, every one of the 50 states had to pass that legislation, and only consensus would allow this to happen. You can imagine that the US would never borrow a cent, if that were the case. So that's more or less the procedure that would be required to increase the issuance of euro safe assets. It's not a large quantity now, and there's really no future without major institutional change.

Beckworth:  I also wonder if this safe asset shortage is tied to the first fact, that the dollar's so dominant. There's huge network effects. So last year, at the Jackson Hole meetings, the former head governor at the Bank of England, Mark Carney, made a proposal for a synthetic hegemonic currency. SHC. It's a mouthful. But the idea he articulated was that all the central banks would issue digital currencies which would be backed by their currencies or other currencies. And these currencies would then, I believe, be backed by another one. But ultimately the point was to create a synthetic hegemonic currency, a dominant currency, that could displace the dollar. And there is this whole literature... I know you've worked on it, and you've delved in it... how dollar dominance can have these adverse effects. Whenever the dollar goes up in value, the Fed tightens, and so forth. And his point was we need to get some alternative to it.

Beckworth:  The challenge though, and I was talking to some people afterwards about this, there are just so many dollar assets. You alluded to this earlier. It's not just Treasury debt, but corporate debt, bank account... I mean, all these liquid assets. The US is a banker to the world, right? And so there's just trillions and trillions. One estimate showed 30 trillion in terms of liquid assets, if you count everything. Other measures show more. It doesn't seem very easy or tractable to try to suddenly create that many assets and compete, or at least half of that, if we slice the pie into. So it seems like the fact that the dollar is so dominant, there's this network effect, assets are created in dollar denomination, it's a huge head start that makes it really difficult for the ECB, the EU to catch up.

Ilzetzki:  Yeah. No. So, I agree. I have a lot of respect for the views of Mark Carney on this topic, but we've been there before. If you go back far enough, commentators thought the SDR, the IMF's special drawing rights, are going to be an alternative, going to be sort of a basket currency as an alternative to the dollar. It's not the first time proposals like this come up. But yeah. I would add to the list, when you talk about liquid assets, you might think the stock market is irrelevant because it's really not inherently denominated in any currency. It's simply tied to the dividends of the corporations. But nevertheless, if you want to invest in the S&P 500, then there's going to be some dollar transaction that's going to happen there, and not a pound transaction or a globo currency transaction. The market capitalization of the US stock markets is larger than the stock market capitalization of the rest of the world combined. Even if you think of slightly less safe assets like stocks, simply assets, a portfolio of assets, you're going to end up with a large dollar share.

Beckworth:  Yeah. So some of the global financial cycle literature and then others have dubbed it the global dollar cycle. Whenever there's a crisis, a global crisis, dollar-denominated assets abroad actually grow because people are getting out of these riskier assets. The BIS keeps track of this 13 trillion dollar number that... These are dollar liabilities created outside the US, and they actually grow. It seems like a tough nut to crack. And maybe we've reached this point. So let me ask you a question along these lines, Ethan. I ask lots of folks. I love these counterfactuals. But let's say we could start the Earth over again, and we could run it, say, 10,000 times. So we're going to do Monte Carlo simulations of Earth's history here. Would we always end up with one dominant currency? Because of network effects, have a money of moneys? Is this an inevitable outcome, or could we have multiple reserve currencies?

Ilzetzki:  My sense is that there is a strong network effect. I don't want to say never. I could envision a world that is tri-polar, with, say, the dollar, the renminbi, and the euro taking equal shares. So I could imagine that as an equilibrium to the system. It's very hard to see the transition from the current status quo to that situation. Barry Eichengreen has argued in his books that that's where we're going. But even he appears to acknowledge that, at the moment, Europe is punching below its weight, is far from that position. And it's probably a little premature to think of the Chinese currency, that's still not really an internationally traded currency, as having a global role.

Ilzetzki:  In abstract, I think there could be an equilibrium where there is multiple currencies sharing the stage, and maybe even a stable equilibrium. But I think the current equilibrium is extremely stable, at least for now. In thinking about how this comes about, you would have to see a major disruption in the role of the US in the world, I think on multiple dimensions, for this happen. If you look at what's happening in the world, it's not unthinkable. But I think that's still a tail event.

In abstract, I think there could be an equilibrium where there is multiple currencies sharing the stage, and maybe even a stable equilibrium. But I think the current equilibrium is extremely stable, at least for now.

Beckworth:  Yeah. Again, because there's so many dollar assets out there, the scale just far exceeds anything else, it would take a breakdown of the US as a country, something really serious... breakdown, secession, something really dramatic... that might just be my take. Or we finally get aliens to visit Earth, and we start trading with some other planet where there's something even bigger and stronger than the US. So I agree. I think we're locked into this equilibrium. It seems very stable. And it'd be interesting to see how this unfolds going forward.

Beckworth:  Okay, let's segue into another interesting paper you have coauthored with Ken Rogoff and Carmen Reinhart. And this is one that you gave recently at the Brookings Institute. And this one also deals with international monetary issues. And the title of this paper is *Will the Secular Decline in Exchange Rate and Inflation Volatility Survive COVID-19?* So, why don't you start us off with what are you documenting? What are you bringing to our attention that you want to talk about in this paper?

Secular Declines in Exchange Rates and Inflation Volatility

Ilzetzki:  Yeah. Let me give you a little bit of a background for this paper. We proposed this paper to Brookings, as part of the panel on economic activity, early on during the COVID-19 pandemic. So I think it was around March when we first proposed it. And looking at the world around us, we were pretty persuaded that the stable equilibrium of the Bretton Woods II system... And I'll talk more what I mean by that in a moment. But the stable equilibrium of the international monetary system of the 21st century is going to face a challenge that will end its enormous stability. And as we worked on this paper through the summer, we realized that we can't really write that paper that we wanted to write, because this international monetary system showed a resilience that was surprising to us. And so really, the theme of the paper changed to documenting the surprising resilience and stability, and asking whether that stability can survive going forward.

Ilzetzki:  Now, let me now describe what that stability is. So, there has been a secular decline, so kind of just a trend decline, in the volatility of major high-income country currencies, primarily what we call the G3, the dollar, the euro, and the yen. So we take the three most traded currencies and look at how volatile their exchange rates are. That has been declining systematically since 2000. When you take a closer look, both visually, as you can see in the charts in the paper, and with more formal empirical tests, you see that there is a sharp further downward break in that trend somewhere in the middle of 2014. And since 2014, the stability of the dollar, euro, and yen exchange rates has been, by some metrics, unprecedented.

Ilzetzki:  So what do I mean by that? If you compare the volatility of these currencies to the volatility of other assets like oil or the stock market, you will see that the major currencies are moving more tightly together than they did even during most of the Bretton Woods system of fixed exchange rates. And this is not something we would have predicted. Right? So this is when we moved to a system of flexible exchange rates after Breton Woods, everyone's expectation was that exchange rate would, particularly among these floating major currencies, would be very volatile. And indeed they were for the first few decades. But now it's just been a strong trend towards more stability. That's kind of the remarkable fact that we point out

Since 2014, the stability of the dollar, euro, and yen exchange rates has been, by some metrics, unprecedented... If you compare the volatility of these currencies to the volatility of other assets like oil or the stock market, you will see that the major currencies are moving more tightly together than they did even during most of the Bretton Woods system of fixed exchange rates.

Beckworth:  Yeah. Isn't that something that Robert Mundell was advocating? He almost argued for a fixed global exchange rate system. But we effectively are there already, right?

Ilzetzki:  Yeah. So in some sense, the ambitions of Bretton Woods, or the ambitions of the global currency advocates, may be de facto realizing in front of our eyes. We'll talk, I'm sure, about why this may not persist. But for now, there is a stability that is by some measures unprecedented, and certainly unpredicted.

Beckworth:  Yeah. So, tying this into the news, Judy Shelton looks like she's not going to make it to the Board of Governors. But for a long time she's been advocating this very thing because she's a follower of Mundell. And it's surprising. I wanted to say, "Look, Judy, you have already what you've been advocating. You got this system that effectively has linked..." Not linked, but they definitely look like they're linked, and they move together. This is pretty remarkable, as you said, in a floating exchange rate world. This is not what Milton Friedman predicted, right, in his classic paper.

Ilzetzki:  That's right. Yeah. Well, let me get back to Dornbusch later on, maybe. Or maybe I can talk about Dornbusch.

Ilzetzki:  So, Rudi Dornbusch, who was to some extent the father of modern international macroeconomics, or one of the fathers maybe, predicted in his sort of overshooting theories of exchange rates that once we let go of the pegs, exchange rate volatility would be much larger and that monetary policy would be a major driver of the volatility of exchange rates. And indeed, the first decades seemed to vindicate him. But in this paper, we argue that, actually, also the stability in the recent period seems to vindicate the Dornbusch view that monetary policy is the main determinant of exchange rate volatility. Because, now turning to why we think this is going on, if you try to look at the list of potential culprits for why exchanges rates are so stable... The paper goes one by one through the potential culprits, and most of them are just pretty easy to reject, just based on casual observation. So it could be that exchange rates are more stable because the world is a more stable place.

In this paper, we argue that, actually, also the stability in the recent period seems to vindicate the Dornbusch view that monetary policy is the main determinant of exchange rate volatility.

Ilzetzki:  Now, we're recording this in December 2020, and hopefully the world will be in a better place after the vaccine is distributed, but certainly this year, and the past decade, has not been an uneventful period in terms of economic shocks. If anything, it seems like, in many respects, it's a more volatile period. Indeed, when you look at the stock market, and we show this in the paper, two of the largest volatility events in recorded history of the stock market occurred in the 21st century, which are, obviously, the global financial crisis and COVID-19. But you don't see a commensurate movement in exchange rates. So it's hard to argue that financial stability, general economic stability, is what's driving the stability of exchange rates.

Ilzetzki:  In contrast, if you think about monetary policy, which is now at zero in all major economies, if the main thing that drives exchange rates are interest rate differentials... And in fact, the theory would say that it's long-term interest rate differentials that would determine exchange rate volatility, or the volatility of long-run interest rate differentials. This is an unprecedented period in which all major currencies have essentially zero interest rates, even in 10-year bonds. The variability in interest rates is so small across major currencies that if interest rates or monetary policy are the main drivers of exchange rate volatility, there's nothing really to move exchange rates around.

Beckworth:  Yeah. And I think that's a great explanation. And really enjoyed this paper. But it raises a question. Why have we headed into the zero lower bound world, right? Why has monetary policy converged in the zero lower bound? And think this goes back to safe asset, secular stagnation discussions, that there are these exogenous forces out there. And I think one of the interesting things about safe assets, and something's that tied to what you also mention in the paper, is that inflation also has kind of followed the exchange rate stability down. And the G3 move together.

Beckworth:  I see a connection between the safe asset demand and the low inflation, and one that I don't think's been... I don't know... covered enough in the literature. The safe asset literature often looks at this problem as the contagion, or spread, of equilibrium rates dropping around the world, and dropping below actual market rates, and creates output gaps and eventually gets to inflation. But I think a big part of why we had low inflation... Going back to our earlier question or point about the ECB, the Fed, why has there been persistent low inflation? I think this demand for safe assets is a big part of the story. And I'd like to hear what you think about that.

Inflation and the Lack of Demand for Safe Assets

Ilzetzki:  Yeah. I think that is a plausible explanation. I should preface by saying that I don't know the answer to this question. I'm not sure anybody knows it with much confidence. I think the reasons for low inflation and stable inflation are somewhat elusive. I know that central banks want to claim that this is their making, and I think to some extent this is true. But I'll put it to the following empirical test, that you have 200 countries in the world or so, not all of whose central banks have followed the conventional prescriptions. And with a very small number of exceptions, like Venezuela, Argentina, Zimbabwe, there's really been extremely low inflation throughout the world. So again, coming back to our earlier discussion, there's a possibility that there's about 190 correlated positive events here or that there is something global that's going on. So I think we need to look at these global factors in thinking about that.

Ilzetzki:  So the factor that you're suggesting is perhaps thinking about global liquidity of safe assets vis-à-vis the quantity of goods and services. And indeed, a shortage of the liquidity could lead to a... So that would be a potential explanation. We don't explore that in our paper, but I think that's a very interesting avenue

Beckworth:  No, I'm glad you brought up that quantity theoretic kind of approach to safe assets because that's the angle I'm taking in my work. And as I mentioned, most of the safe asset literature takes more of a... I call a New Keynesian flavor to it. It's all about equilibrium rates marching down through arbitrage and likewise inflation. I mean, the reason this correlation's there is because we've got global capital markets. But again, they tell the story. It's the equilibrium rates are dropping below maybe actual market rates. You get an output gap or a weak economy, and from there, invoking Phillips Curve, thinking you get the low inflation, where I like the story you just told that these safe assets are highly liquid. They're effectively a form of money, especially for institutional investors. They're a transaction asset, and if there's not enough of them in simple quantity exchange, there's going to be some downward pressure on prices. I think that's an important story to tell, one that hasn't been told enough. So pleasantly surprised to hear you bring it up.

Ilzetzki:  Yeah. Keep it up, David. I do think we need to think more about the international economy. In the study of these questions, most of the discussions are thinking about each domestic economy in isolation, or maybe having that isolated economy have a current account and a capital account that is open. But still the shocks and the driving factors are typically domestic to one of those countries, as opposed to being these global trends, which in a world of increased globalization, a trend that may or may not reverse going forward but that has been an uptrend to greater globalization over the past few decades, you would think that there should be more explanations for phenomena that are coming from the global factors. I applaud you pushing in that direction.

Beckworth:  And to be clear, what we're talking about here, a safe asset shortage, is really just a symptom of a deeper problem, right? What's causing that? There's lots of stories have been told. I think many of them are true. Population. The world's aging in the advanced economies, even in China. Productivity growth has slowed down. There's a lot of exogenous things going on simultaneously. They could change in the future. Who knows? Things could change in the future, but for now they seem to be pointing towards a persistent safe asset shortage problem. Let me move to one of the explanations in this paper that you and your coauthors reject. I want to push back a little bit, Ethan.

Beckworth:  You're a good friend, but I'm going to push back here. So, you mentioned that one explanation for the stability is the Fed's interventions, and use of swap lines, and basically jumping into the global financial system and bailing out what I would call the global shadow banking system, all the dollars created around the world as well as the US. And you're right. It happened in 2008. It happened now. And you mentioned... I'll read a quote here. You put, "COVID-19 central bank swap lines never reached the magnitudes of those in the Great Financial Crisis. Further, by now the ECB has almost entirely drawn down its swap line balances, and the Bank of Japan has unwound three-quarters of its holding." So the point you're making is this could be a potential explanation, but it's not, because it really hasn't been used, or the quantities don't seem to be there. But couldn't one take another view of that observation? Say, "Look, this is like FDIC," right? We haven't had a major retail bank run in the US since the Great Depression because of FDIC, but FDIC hasn't been drawn upon a lot, either.

Beckworth:  I mean, the fact the Fed is sitting there, ready to move... And I think that, this year in particular, the extent that it went really demonstrates to the world, "Man, the Fed really is going to backstop every liquid financial asset that's tied to the dollar in some form."

Ilzetzki:  Yeah. So, we don't reject entirely the swap line story, and we don't have a counterfactual of how volatile the system would have been absent the swap lines. So absolutely, we're very open to the notion that that played a role. My colleague Ricardo Reis has empirical work on the role of the swap lines. And there does seem to be some causal link there. Listeners can also the read the discussion of our commentator in the conference, Sylvia Miranda-Agrippino, who also pushed back in a similar vein that swap lines were used. But the reason we believe that that can't be a major part of the story is simply the matter of the timing of the phenomena we're talking about. As I pointed out... And you can see this visually on the charts in the paper. They're quite striking. You just see a staggering drop in volatility somewhere around the middle of 2014. That dating is verified through formal breakpoint tests, statistical breakpoint tests.

Ilzetzki:  So something is happening well before COVID-19. And something is changing around 2014. Now, obviously, a lot of things may have happened around that time. But if you look at the timing, it fits very well with our story, in the sense that this is precisely the time where the ECB goes to negative interest rates for the first time. Around this time, the German and Japanese government bond yields start going negative, even at 10-year maturities. And so the timing fits very, very nicely with this lack of interest rate movement. We're happy to entertain other things that happened around that time, but certainly swap lines were not a major topic of discussion in exchange rate markets at that point in time.

Beckworth:  No. That's completely fair. The timing. Let me reframe this in a complementary fashion. Maybe this complements your story. To me, your story ultimately is, "Is zero lower bounds getting more firm hold on these advanced economies?" 2014's a particularly good inflection point. So let me put it this way. The dollar swap lines, one, further confirm that, because now if you're a global investor, on the margin, should I have a dollar asset in my portfolio? You definitely do because you know the Fed's there. So that's going to increase demand for all dollar-denominated assets. Seigniorage flows to the US. Deflationary pressures. But maybe in 2014, it’s on the margin... I mean, again, this is a complementary story. The zero lower bound is occurring, and it's marching down because there is this expectation maybe the dollar swap lines will be used in the future. I don't think that's the key story here. I think you're right. But it's the demand for safe assets is the core story, but that demand for safe assets might be why the Fed does step in. It's hard to disentangle them entirely.

Ilzetzki:  Sure. Look, I think the swap lines were a big deal, and they were important. And I think their presence is a welcome addition to the policy tool kit. All else equal, the sign of the effect is the right sign. That is it would lead to lower volatility, all else equal.

Beckworth:  But the timing's off. Your point is for the timing, it's not there.

Ilzetzki:  Yeah, definitely.

Beckworth:  Okay. It's icing on the cake. It's not the cake itself. Okay, fair enough. Well, what about inflation? We have a few minutes left. What about the prospects for inflation? One thing you raise in the paper is this low inflation might change. So what might break this equilibrium we're in?

Prospects for Inflation in the Future

Ilzetzki:  Yeah. I want to preface this that in the short run, I am not concerned about inflation. And if I think, for example, about Congress now debating a fiscal package, I would err on just trying to save the economy, and people who are suffering, as much as possible, as opposed to worrying that public debt may lead to inflation someday in the future. So in the short run, I don't want to be alarmist. And to be frank, market expectations are telling us that they don't think inflation is going to be high in the foreseeable future.

In the short run, I am not concerned about inflation. And if I think, for example, about Congress now debating a fiscal package, I would err on just trying to save the economy, and people who are suffering, as much as possible, as opposed to worrying that public debt may lead to inflation someday in the future.

Ilzetzki:  I find the consensus, that there is no way that inflation will be a problem in our lifetime, to be the type of consensuses that worry me a little bit because it's precisely those consensuses that hit us in the face at some point. So while I defer to market participants and others in forecasting what will happen, my coauthors and I wanted to point out that we should not think of it as a foregone conclusion that inflation isn't going to be a problem. And it really depends, at that point, why you think inflation was low to begin with. You mentioned demographics. If you believe that it's demographic factors that have been driving low interest rates and low inflation, those demographic trends are likely to reverse at some point. China has ended its one-child policy. Europe will not age forever. Japanese retirees have very high longevity, but they too will need to spend that money at some point, or their children will do so.

Ilzetzki:  So I think if you think, for example, that demographics are the driving force, then you do have to think about the prospect of a reversal at some point. Now, this is not a forecast. Again, to be very clear that this is neither a forecast, nor am I advocating policies to preemptively deal with some tail event of inflation going up. But I think that tail is fatter, in the sense that it's a more probable event than I think most observers are putting on it at the moment. I think the implied probability of that happening, based on what you hear economists saying and what you see in market trading of inflation-based assets, is essentially zero. And when people think that there's a zero probability of something, that's where I look for the dangers.

While I defer to market participants and others in forecasting what will happen, my coauthors and I wanted to point out that we should not think of it as a foregone conclusion that inflation isn't going to be a problem. And it really depends, at that point, why you think inflation was low to begin with.

Beckworth:  Well, Ethan, our time is up, and it's been a real treat to have you back on. It's always great to chat with you. Now, I understand you're going to have a virtual AEA event that people can follow. So if they want more of you and your work, and a panel... Tell us about that panel. And when is it?

Ilzetzki:  Yeah. So, I'm chairing a session at the American Economic Association meetings at the beginning of January. So registration is still open. I encourage listeners to participate in the meetings and in our session. Our session is about fiscal policy in times of pandemic and war, which is somewhat timely. And there's some very interesting papers there, by some excellent economists, on how fiscal policy works in times like these. My own paper is on the effects of fiscal policy during the Second World War, but there's also papers on fiscal policy during pandemics, and how to deal with long-term debt. And so I think it will be a very interesting session, and I invite everyone to join.

Beckworth:  Sounds fascinating. So check it out. Ethan, thank you again for coming on the show.

Ilzetzki:  Thanks so much, David.

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